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February 26, 2013

WARNING: Fed Candy May Be Hazardous to Your Wealth

The Federal Reserve Board is the purveyor of monetary policy which includes maintaining an adequate supply of capital to foster economic growth. Like any enterprise, the organization has a balance sheet with assets and liabilities. What's of particular concern to me and many others is the increase in the size and scope of the Fed's financial statement since the financial crisis of 2008-2009.

In this post, we'll take a look at how the amount of capital has grown in the system over the past 30 years and how far the Fed has deviated from normal operations. Although the danger may not be imminent, as advisors we should give thought to possible consequences of Fed actions and how it could affect the wealth of our clients.

Fed's Balance Sheet

When the crisis hit in 2008, the Fed's balance sheet was around $800 billion. Today, it is near $3.1 trillion, or nearly four times larger! Moreover, the Fed continues to pump in over $80 billion in new stimulus each month and plans to do so until unemployment reaches 6.5%. With the additional costs and regulations relating to Obamacare, businesses are bracing for a negative economic impact, the magnitude of which cannot easily be surmised. Add to this the expiration of the payroll tax cut and higher taxes on the wealthy and it may be some time before the Fed’s easy money policy reverses course. In short, the Fed's balance sheet could grow quite a bit larger before they're finished fighting this fire.

Bubble? Inflation? Deflation?

In the meantime, given the excess liquidity in the system, stocks appear poised to rise. Is there another Fed-manufactured bubble brewing? Perhaps, but not immediately. Here's another issue. How will the Fed unwind such a massive amount of stimulus in a way that doesn't cause a serious market disruption? If the Fed simply lets this money filter into the system, inflation could spike and make the late 1970s look like a fire sale. If the Fed unwinds too aggressively, the lack of liquidity could cause interest rates to spike and the velocity of money to slow, thereby creating another recession.

M2 to GDP Ratio

Obviously the Fed puts money into the system to get the wheels of commerce turning. However, the amount of M2 in the system as a percentage of GDP has increased greatly over the years. For example, in January 1981, there was $1.6 trillion of M2 Money Stock and a GDP of $6.0 trillion; M2 was 27% of total GDP at that time. Just prior to the 2008 crisis (October 2007), M2 was 55.6% of GDP. Currently M2 is 75.5% of GDP. This ratio has been rising steadily since 1981. What does this suggest? Because credit rules and banks tightened their lending standards so much after the crisis, among other factors, the economy has been very slow to respond.

The Future?

How long will the Fed continue to "stimulate" the economy? How large will its balance sheet grow before it begins to tighten? When economic activity does normalize, will the Fed be able to remove the excess capital from the system without causing demand destruction? If the Fed reacts too slowly, will inflation put a real damper on the economy?

As usual, we have more questions than answers. Many times our answers are just speculation in disguise. One thing for sure, the manner in which the Fed proceeds will have a real impact on the creation and preservation of wealth. Couple this with the persistent trillion dollar fiscal deficits and a burgeoning national debt, and you have the makings for a financial Alfred Hitchcock flick. I think I'll go out for popcorn. It's gonna be a long movie!

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